Deductibility of debts for Inheritance Tax
The Finance Act 2013 introduced a change which limits the deductibility of debts in certain circumstances.
The change in legislation is primarily aimed at tackling tax avoidance schemes under which money is borrowed by an individual but then used to buy property which then is either excluded property or benefits from a relief such as business property or agricultural property relief.
But it can also catch people who are looking to expand their business or even purchase a share in a business for the first time and need to raise funds to do this.
An example may help. Jerry owns a house worth £1.5m and has agreed to purchase an interest in an unquoted trading company. To fund the purchase he has borrowed £1.2m and the bank have taken a charge over his house as security for the loan. Four years later Jerry dies and his shares in the business are worth only £1m and his house is still worth £1.5m.
Prior to the change Jerry would have had no IHT liability (assuming he had no other assets) as his shares would qualify for 100% business property relief and the loan would be deducted from the value of his house. This would leave a net estate of only £300,000 which is below the inheritance tax nil rate band of £325,000.
However following the change the loan would now be used to reduce the value of his shares first. As the loan is more than the value of the shares their value for IHT purposes will still be zero. But this means that only £200,000 is potentially available to be deducted from the value of his house.
This therefore gives rise to an inheritance tax liability of at least £390,000 where no liability existed before. But there is a further sting in the tail waiting for Jerry.
As a result
But all is not lost. HMRC have very kindly given a solution to at least part of the problem they have created. You will find this in the guidance in their Inheritance Tax Manual. This states that if the executors borrow money to repay the original mortgage and this new loan is secured on the property so that the beneficiary receives the property charged with the new debt, it can be accepted that the original mortgage has been repaid from the estate.
The guidance goes on to say that the beneficiary may even make a loan to the executors from the proceeds of an insurance policy held in trust outside the estate for the purposes of repaying the mortgage. The source of the funds does not matter.
So in Jerry’s case it is possible that between them, his executors and beneficiaries can reduce the liability by £80,000 simply by following the steps above. But that still leaves the liability of £390,000. As Jerry has no other assets, either the house or some of the shares will need to be sold to fund this. This of course is not what Jerry had hoped.
The obvious option is for Jerry to take out additional cover under a whole of life policy. This would be written in trust for the benefit of his family to ensure they have immediate access to the funds necessary to pay the inheritance tax liability. This avoids the need for the family home to be sold and allows for either a more orderly disposal of Jerry’s shares or one of the beneficiaries of his estate to take on being part of the business.
And this doesn’t just affect new arrangements. It affects anyone who dies on or after 17 July 2013. There is therefore a good reason to review protection arrangements for existing clients as well as new and to make contact to make sure they understand the liabilities they or their family may now face.
Many people caught by this won’t have other strategies available to them and are unlikely to be aware of the problem unless pointed out by an adviser. So while the door for one tax planning route may have been firmly closed, there can be no doubt that the door for protection to be used in inheritance tax planning has been pushed further open.
The information provided is based on our current understanding of the relevant legislation and regulations and may be subject to alteration as a result of changes in legislation or practice. Also it may not reflect the options available under a specific product which may not be as wide as legislations and regulations allow.
All references to taxation are based on our understanding of current taxation law and practice and may be affected by future changes in legislation and the individual circumstances of the investor.